The balance sheet or statement of financial position gives a snapshot view of the financial status of a firm at any point in time by outlining its assets, liabilities, and equity.
The Golden Rule of the Balance Sheet specifies the general principles guiding the assurance that the firm’s financial statements balance, are accurate, and comply with all the accounting standards.
A golden rule of the balance sheet is that assets have always to equate with liabilities and equity. It is the basic principle of double entry accounting; hence it is the sound basis to ensure accuracy and consistency in financial records.
In this article, the golden rule of the balance sheet is highlighted by explaining its importance, balance equation, and essential elements to come in the balance into a company’s financial records.
1. Equation of the Balance Sheet
Assets = Liabilities + Equity
This equation presents the golden rule of a balance sheet that says everything that a company owns is financed either through borrowing or by the investment by the shareholders. On this equation, both the sides represent one point in the financial situation of the company and they will have to be equal at all times.
•Assets: This business owns resources that have value and are supposed to contribute toward future benefits. Assets include cash, accounts receivable, inventory, equipment, and real estate.
•Liabilities: Obligations the company owes to external parties. Liabilities are loans, accounts payable, and accrued expenses.
•Equity: Shareholders’ claim on assets that remain after paying all of the liabilities. It is known as net assets or net worth; common stock, retained earnings, and additional paid-in capital are all part of it.
The balance sheet equation ensures that every transaction impacts the balance sheet in a way that keeps the assets balanced against liabilities and equity.
2. Why the Golden Rule Applies
Why the golden rule of the balance sheet becomes important has to do with the following factors:
•It ensures that financial statements are highly accurate by maintaining the balance sheet equation, which minimizes mistakes in financial reporting.
•Serves as a basis of transparency and accountability: A balanced balance sheet provides insight into the financial position of a company and allows investors and creditors to evaluate the financial health of the company.
This is where Double-Entry Accounting begins: All the transactions in double-entry accounting involve debits and credits. This balances all the financial statements.
As divided into three sections in the most basic form, the asset, liability, and equity balance sheet categories contribute to the overall balance equation. All must be included when such analysis is considered as each reflects a different perspective of the company’s financial state.
Assets
Assets are the things owned or possessed by a business. There are two types of assets: current or non-current-fixer assets:
• Current Assets These are the assets that the company expects to use up or sell in cash within one year. This includes cash, accounts receivable, and inventory.
• Non-Current Assets: These are the ones that are of longer terms; it will hardly be able to liquidate within one year. They include property, plant, and equipment as well as intangible assets like patents and trademarks.
Liabilities
The company is responsible to pay debts or offer services to other companies. Liabilities are further classified into two types: current liabilities and non-current liabilities:
• Current Liabilities Current liabilities are those which fall due within a period of one year, including accounts payable, short-term loans, and accrued expenses.
• Non-Current Liabilities Long-term loans, bonds payable, and pension obligations are debts payable after a period of one year.
Equity
Equity is also known as shareholders’ equity or owners’ equity. Residual interest left in the firm’s assets after subtracting all liabilities is equity. Some of the basic elements that constitute equity include: Common Stock: These are shares of the company subscribed by the shareholders in lieu of ownership.
Retained Earnings: Profit earned by the business entity which has not been distributed to the owners as dividends but is retained with the business either for reinvestment or debt servicing purposes.
Paid-In Capital: These are funds received from shareholders above the par value of the stock.
4. Balance: Balance Sheet Equation
Every transaction must have a balancing effect, both sides of the equation, or change two items on the same side of the equation in a way that brings the balancing item to balance it so the balance sheet equation continues to stay balanced.
Example 1: Cash Purchase of Inventory
When using cash to purchase inventory, the implication of such an action on both sides of the balance sheet is:
•Assets: Inventory increased and cash decreased in the same amount.
•Effect: The total amount of assets is not altered since it will be the same for an equation that is still balanced.
Example 2: Borrowing Loan
When a firm borrows $10,000 from the bank, then the liabilities and assets are affected
•Assets: Cash increased by $10,000.
•Liabilities: Loans payable is a liability that increased by $10,000.
• Effect: The balance of the equation would still be maintained since the increase in assets will be offset by an increase in liabilities.
Example 3: Earned Net Income
In case a firm earns some net income, then its effect on equity would be as follows:
• The assets: Cash or accounts receivable may be increased due to a cash or credit sale.
• The equity: Retained earnings would increase by the amount of net income.
• Result: The equation is still in balance because an increase in assets is matched with an increase in equity.
From the above example one can clearly see that any transaction tends to affect the balance sheet in two ways so that the assets, liabilities, and equity remain in balance.
5. Key Issues to Maintain Golden Rule
For a firm to be able to follow the golden rule of the balance sheet, then it has to address the following issues;
•Double Entry Accounting: All financial transactions must have both debit and credit entries, such that the equation of the balance sheet holds.
•Accuracy of General Ledger Entries: The accuracy of general ledger entries holds a paramount position such that errors are not allowed to mar the balance.
• Account Reconciliation Periodically: Account reconciliation on periodic basis shall reflect and rectify errors before they strike the balance sheet.
• Consistency in use of accounting standards: Use of accounting standards (GAAP or IFRS) ensures preparation of balance sheet in the same forms, with no mistakes.
• Adjusting Entries: There may be adjustments of depreciation, accruals, and so on to be taken care of with perfect transactions to avoid imbalances.
6. Problems for Balances to be Kept
However beautiful the golden rule of the balance sheet may look; balance is rather tough to be maintained when for example:
•Complex Transactions: It becomes quite challenging to make a record of mergers, acquisitions and so on without causing imbalances.
•Errors in Posting: This can also arise due to journal entries or ledger postings.
• Unrecorded Adjustments: Failure to record some adjustments like accruals or depreciation may imperil to balance the account.
• Currency Exchange Rates: Variations in exchange rates may cause foreign assets to increase a multinational organization’s balance vice-versa.
7. Conclusion
The rule of thumb of the balance sheet should ensure that assets equal liabilities plus equity acts as a basis of proper financial reporting.
This rule is based on the balance sheet equation as part of a fundamental component of double-entry accounting, and it enables investors, creditors, as well as managers to have an adequate and transparent view of the company’s position.
These measures ensuring that accruing according to this principle makes companies as transparent and accountable as they can be in terms of compliance and standards in accounting.
The balance sheet golden rule, the last thing to remember, is, of course, another very important tool in the evaluation of the financial health and stability of any company.